Larry Elliott : A Second Look
The Great Fire of London began in Pudding Lane and raged uncontrollably for days. When the flames died down, large parts of London had been reduced to smouldering heaps of ash.
With the benefit of hindsight, the Great Fire was not a disaster. London recovered quickly and the authorities learned from their mistakes when it came to rebuilding the city.
But that was not the way it seemed in September 1666 as the flames swept through the streets of London. The sense of helplessness and panic will have been familiar to those at the sharp end of the current financial turmoil.
The solution arrived at in 1666 was to call in troops to blow up blocks of houses, creating a firebreak. Once that was done, the fire burned itself out. Can something similar be done in the world’s financial markets today?
The short answer is that something similar can be tried – and almost certainly will be tried – but there is no guarantee of success. Globalisation has meant that the linkages between economies are so strong that the creation of cordons sanitaires is not easy. But there are four countries essential to managing the financial crisis: Brazil, Hong Kong, Japan and the United States.
Brazil raised interest rates to 50% last week in an attempt to put a halt to capital flight and head off a disorderly devaluation that would have ramifications not only for Argentina and Mexico, but also for the US and European Union. The US banking system is twice as exposed to Latin America as it is to Asia; the combined exposure of European banks is even higher.
Reports from Washington last weekend suggested the US Treasury and the International Monetary Fund (IMF) were trying to patch together a rescue plan. Having screwed up badly in Russia, the West must get it right in Brazil, a country which at least has a functioning government and a system of (little-used) capital controls that could be beefed up to deter speculation.
The willingness of President Fernando Henrique Cardoso’s government to tighten monetary policy and cut spending should be met with a response from Washington. But building a firewall will not come cheap: a fund of at least $25-billion will be needed to tide Brazil over.
Hong Kong has taken a different route. In effect, the authorities have defended the currency peg with the US dollar by nationalising the stock market. What was once the darling of free-market commentators has proved to be the biggest interventionist of all – pushing up prices and causing real damage to the hedge funds (which are also reported to have taken a battering in Russia).
The Hong Kong monetary authority is following up this blatant (and laudable) tampering with the market mechanism by regulating short selling and placing restrictions on the use of margin calls.
Hong Kong’s chances of clinging to its currency peg depend to a large extent on what happens to China, and that in turn will be influenced by what happens in Japan. Amid all the stock market turbulence of the past month, it has almost been forgotten that Asia is gripped by a serious depression and there is no prospect of a recovery until 2000, at the earliest.
United Kingdom Chancellor Gordon Brown, as chair of the Group of Seven leading industrial nations, is flying to Japan for talks this week, and it is clear that the sooner the world’s second economy can be dragged out of its prolonged slump, the better. Whether he can provide anything other than moral support remains to be seen; most of the solutions to Japan’s problems are in its own hands.
The authorities must staunch the flow of corporate bankruptcies and stimulate consumer confidence, but this is proving difficult. With prices falling, money is becoming more valuable and consumers are hoarding it rather than spending it. Printing money in order to push up prices may be the only way out, because that would reduce the incentive to save.
Finally, there is the US. As in 1973/74, a global economic crisis has come at a time when the US presidency has been weakened. Declining corporate earnings meant that Wall Street was due for a fall from its dizzy heights in any event, but the uncertainty surrounding President Bill Clinton is unhelpful for market sentiment.
With large parts of the world suffering from full-scale deflation, it is up to the US – despite its record trade deficit – and Europe to try to act as the buyers of last resort, providing a ready market for world output. But the chances of this happening are slim if the Dow Jones and the dollar continue to crash. If Clinton falls on his sword over the next few weeks, it will not be because of the congressmen on Capitol Hill but because of the financiers on Wall Street.
Ultimately, it may prove impossible to ring-fence Brazil and Hong Kong, end Japan’s long recession and maintain robust US growth. It may be that a combination of over-production and structural deficiencies in the global financial structure will coalesce to turn a cyclical downturn into something much nastier. It may be that the herd instinct of markets prevents sensible policies from working.
But the debate now is about the form intervention should take, rather than whether it should happen. There is a sense that a dam has broken and all sorts of progressive ideas can now be discussed.
David Hale, chief economist for the Zurich Group, for example, is expressing concern about the power of the 4 000 US hedge funds and bank proprietary departments, with $250-billion of capital dedicated to short- term trading activity, to destabilise small and medium-size countries which are not equipped to cope with mass selling of their currencies or equity markets.
History shows the Great Fire helped to purge the Great Plague of the previous year. The industrial West will survive the present crisis, but a long-overdue cleansing process has begun.
l The IMF has warned it is so strapped for cash after record levels of lending that it may be forced to borrow directly from its richer shareholders to deal with future global financial emergencies. Its problems have been exacerbated by the USCongress’s failure to approve a capital increase to the fund.
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